30 Dec 2009

A Quick Note on Recapitalization

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In November of 2008 I had a long phone conversation with the impregnable von Pepe, which clarified the typical discussions of the financial crisis in light of my hazy knowledge of accounting. In fact I was so energized after the call that I set out to do a whole series of blog posts sharing my newfound understanding.

Well that never happened. But I had another talk with von Pepe tonight and something really clicked, so I thought I would share it verbally (i.e. without coming up with a hypothetical balance sheet to illustrate the idea) while it’s still fresh.

One last point before we dive in: I am going out of my way to “not get it” in the analysis below. Before my talk with von Pepe, it’s not that I doubted the conventional wisdom on these matters, but I just had my doubts and wasn’t sure how to dispel them.


Here’s the context: After the crisis, you heard many commentators say things like, “The banks took huge hits on their holdings of mortgage-backed securities and standard loans. After writing down their assets, they have very little equity remaining. They need to issue more stock to recapitalize themselves.”

Now here were two vague concerns I had with this type of statement:

(1) Why did the firms need to attract new capital through the issuance of stock? If they needed to raise money, couldn’t they just issue more bonds? But then that wouldn’t be a recapitalization, it would be borrowing.

(2) If these firms were on the ropes because of their huge losses, how does that get magically fixed by pumping in more capital? Or to put it another way, why would investors want to buy shares in a company on the verge of bankruptcy? To put it a third way, if the company is solid and outside investors are willing to pump in more money, then who cares if they currently only have a razor-thin margin of shareholders’ equity? What’s a billion here or there in extra losses on MBS holdings if the underlying firm is solid?

The answer to all of the above turns out to be really elementary, but for some reason it didn’t click with me until my phone call tonight. So here it is: When a corporation issues more debt, it is taking on fixed liabilities (to make periodic interest payments and eventually return the principal). If the corporation does really well and has high earnings, then it pays off the bondholders the contractual amount and keeps the rest. On the other hand, if the firm loses money, it still owes the bondholders.

In contrast, if the corporation issues new shares of stock, it isn’t committing itself to future payments. If times are bad, nothing happens. If times are good, however, then the pool of available earnings to be distributed as dividend payments must be spread over a larger number of shares.

So if we’re looking at a financial institution that took huge writedowns on its loan portfolio and holdings of MBS, such that there is only $1 billion in shareholders’ equity compared to (say) $100 billion in outstanding debt, then that firm is incredibly leveraged. If things go smoothly and no further writedowns occur, then it will slowly climb out of its hole and the shareholders will make a killing.

However, if they lose just 1% in the value of their assets, that could wipe them out and they would have to declare bankruptcy. I.e. their liabilities would exceed their remaining assets.

So rather than remain in such a precarious position, the corporation can issue new stock and spread the potential gains and losses among a broader base of capital. If the corporation does well, it dilutes the return to the original shareholders. On the other hand, if things go poorly, the original shareholders aren’t wiped out. In essence they’ve brought in others to reduce both the expected return and its variance.

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